11 - Discounted Cash Flow Approach - Theory

11 - Discounted Cash Flow Approach - Theory - Chapter11

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    Chapter 11 Theory Behind the Discounted Cash  Flow approach
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    The Market Value  Balance Sheet Enterprise value represents the left  hand side
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    Who has a claim on the  Enterprise Value? Either someone else (Debt and  Preferred Stock ) or owned by the  Equity Holders
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What is Enterprise Value? The market value of the assets of the firm Enterprise Value =  Common Equity Value + Preferred  + Market Value Debt – Excess Cash 
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The indirect method of equity  valuation: DCF approach Calculate Enterprise value  Subtract out  Market Value of Debt Preferred Stock Add back excess Cash In practice, many analysts add back all cash to ensure consistency  across firms when performing comparable company analysis 
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How do we calculate Enterprise  Value? Project future cash flows to capital providers Convert each cash flow to a Present Value  equivalent Sum these present value cash flows 
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How do we get the cash flows? Firms have infinite lives, so forecasting all the  cash flows is impossible Forecast 5-10 years of cash flows Calculate the TERMINAL VALUE of the  remaining cash flows
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Note on Terminal Value A common way to estimate the Terminal Value  of a firm is to assume that the business will grow  at a particular rate in perpetuity If you expect the business to grow at 10% per year forever, it  will soon be worth more than an average-sized country! 
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The trick to a reasonable growth  estimate  Forecast the cash flows of the business for a long  enough period of time that you expect it to reach a  "steady state", sustainable long term growth rate  Don't be surprised if your Terminal Value accounts for  more than half of the total value of the business.  DCF values are extremely sensitive to your assumption of what  the business is worth at the end of the forecast period. 
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Calculating the terminal Value Use the Gordon Growth Model g WACC g CF TV t - + = ) 1 (
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Cash flows
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11 - Discounted Cash Flow Approach - Theory - Chapter11

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